Why Do We Need Countercyclical Capital Requirements?
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We show that risk-based capital requirements can eliminate the market failure, caused by asymmetric information between entrepreneurs and banks, which distorts the efficient allocation of low-risk and high-risk investment projects among entrepreneurs. If project success probabilities decline in recessions, optimal capital requirements will have to be lower because the size of the market failure changes. This provides a new rationale for keeping risk-based capital requirements higher in good times and lowering them in bad times.
KeywordsBank regulation Basel III Capital requirements Credit risk Crises Procyclicality
JEL ClassificationD41 D82 G14 G21 G28
We would like to thank for valuable comments an anonymous referee, Iftekhar Hasan, Rocco Huang, Bob Hunt, Timo Korkeamäki, Yrjö Koskinen, Loretta Mester, Alistair Milne, Henri Pages, George Pennacchi, Jean-Charles Rochet, Tuomas Takalo, Jouko Vilmunen, and colleagues at the Bank of Finland workshops as well as participants of the Bank of Finland-Journal of Financial Stability conference in June 2007, Cass Business School Banking Center conference in May 2008, Euroframe conference in June 2009, CEPR/ESI 2009, Bank of Sweden conference in Nov 2009, Deutsche Bundesbank and Technische Universität Dresden workshop in Oct 2010 and seminars at the Banque de France, the ECB, the Federal Reserve Bank of Philadelphia, Goethe University, the Helsinki School of Economics and Hanken, University of Helsinki/RUESG, and University of Illinois at Urbana-Champaign. We are solely responsible for any remaining errors.
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